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What are markets thinking about Brexit?

By Economic Strategist, Hottinger Investment Management

Since the UK voted to leave the European Union in 2016, investors have often looked to currency markets as a barometer of how the final outcome is likely to affect its economy. A narrative has taken hold that a stronger pound indicates a softer, more business-friendly Brexit while a weaker pound portends a no-deal rupture or hard Brexit.

The value of the pound against the euro and the dollar has increased this month, despite the rejection of Prime Minister Theresa May’s deal on January 15th. Since then, enterprising MPs have introduced legislative amendments that carry a number of aims, including allowing Parliament to take control of the Brexit process, delaying the exit date past March 29th, and providing for a second referendum. The upshot, many have concluded, is that a “no-deal” exit is now less likely. Short-term prospects for the UK economy, according to this view, now look better and the stronger pound reflects this.

While there is some truth to this, the picture, as always, is never this simple. Take, for example, the dollar-sterling currency pair. Since the middle of November, when the pound was at its weakest (at around $1.25 per pound) sterling has steadily strengthened, reaching about $1.30 per pound at the time of writing (see Figure 1). One could say this coincides with the news of the UK-EU Withdrawal Agreement, the emergence of which many thought unlikely. However, there was no corresponding bounce in the euro-dollar pair at the time (see Figure 3): that came during December.

A more likely explanation for the stronger pound against the dollar is the growing gap between UK and US interest rate expectations. Since November, investors have been pricing in less monetary tightening in the US and more in the UK. Expectations for the Federal Funds Rate in one year’s time fell from just shy of 3% in November to 2.35% today. Meanwhile, investors now expect the UK’s Bank Rate to be about 5 basis points higher than they did in November. This has made the dollar relatively less attractive and sterling a bit more so.

Figure 1. The grey line shows the price of £1 in terms of dollars (LHS). The blue line shows the difference between UK and US interest rates in one year’s time. Figures valid up until Friday 25th January 2019.

Interest rate developments also explain why investors have been pricing in further strengthening of the pound against the dollar over this calendar year (see Figure 2) but not as much against the euro (Figure 3). The rise in the pound against the euro during December was in line with investors’ expectations for the currency pair at the end of the year.

With the European economy facing recessionary forces, interest rates there are unlikely to rise any time soon. Indeed, last week, on the back of concerns over the state of European banks, we heard Mario Draghi remind the market that the European Central Bank (ECB) carries a number of fire-fighting tools such as targeted longer-term refinancing operations (TLTROs), which are designed to make credit cheaper. TLTROs provide banks with a cheap funding lifeline when their assets are stressed, their credit default spreads on the assets rise and they find it more expensive to borrow against the assets in inter-bank markets. The ECB wheels out TLTROs only when the situation is dire. Draghi said that while there were no plans for a fresh round of TLTRO stimulus, if he were to deploy them he would do so only if they lowered interest rates in the market.

However, with interest rates in the Eurozone already at a record low of -0.4%, it is hard to see how they could go much lower in such a way that would boost sterling. Together with little change in the outlook for UK interest rates, it is no surprise that expectations for the pound-euro pair remain flat.

Figure 2. The grey line shows expected price of £1 in terms of dollars during the fourth quarter of 2019. The blue line shows the current price of £1 in terms of dollars. Figures valid up until Friday 25th January 2019.

Therefore, while currency traders have reacted broadly positively to recent Brexit news, they have not really reflected these developments in their exchange rate expectations for the year. The bounce in sterling during Q4 2018 may simply have allowed the currency to better reflect wider economic fundamentals. Within the general frame of the UK’s leaving the European Union this year, there appears to be little room for further good Brexit-related news to affect exchange rates more than they already have. However, we can’t rule out a big move in both expectations for sterling and its current strength if news emerges that the UK’s trading relationship with Europe will remain as it is for an extended period of time, either through a Norway-style agreement or the announcement of a second referendum with Remain as the favourite. Both of these options seem relatively unlikely at present.

Figure 3. The grey line shows expected price of £1 in terms of euros during the fourth quarter of 2019. The blue line shows the current price of £1 in terms of euros. Figures valid up until Friday 25th January 2019.

Meanwhile, investors still see downside risks associated with a chaotic outcome, but we have to look at the market for gilts to find them. Investors have raised their expectations for UK inflation since the EU referendum. Before the vote, the 5-year breakeven swap – a device that is used to ensure no-arbitrage between ordinary gilts and inflation-linked gilts, and therefore an estimate of annual inflation expectations – was around the Bank of England’s 2% target. Since then, the rate has risen to 3%, suggesting that uncertainty remains heightened (see Figure 4). In particular, it means that bond investors are discounting a possible inflation shock that is delivered by a fall in the value of sterling. In other words, if no-deal becomes likely, investors think sterling could weaken considerably against both the dollar and the euro.

Figure 4. The blue line shows the 5-year UK inflation breakeven swap. This is a market indicator of UK inflation expectations which investors use to ensure that the value of inflation-linked gilts and non-inflation linked gilts is the same. Figures valid up until Friday 25th January 2019.

Therefore, things may be looking up for sterling now, but it is not just good Brexit news that is driving it. Downside risk is still there and we would be wise to avoid complacency.

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